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By Daniel Kurt

For many of today’s investors, diversification goes beyond owning companies in a variety of industries - it means adding securities from different parts of the globe, too. In fact, many wealth management experts recommend diverting a third or more of one's stock allocation into foreign enterprises to create a more efficient portfolio.

But if you’re not aware of the tax treatment of international securities, you’re not maximizing your true earnings potential. When Americans buy stocks or bonds from a company based overseas, any interest, dividends and capital gains are subject to U.S. tax. Here’s the kicker: the government of the firm’s home country may also take a slice.

If this double taxation sounds draconian, take heart. The U.S. tax code offers something called the “Foreign Tax Credit.” Fortunately, this allows you to use all - or at least some - of those foreign taxes to offset your liability to Uncle Sam.

Basics of the Foreign Tax Credit

Every country has its own tax laws, and they can vary dramatically from one government to the next. Many countries have no capital gains tax at all or waive it for foreign investors. But plenty do. Italy, for example, takes 20% of whatever proceeds a non-resident makes from selling his/her stock. Spain withholds slightly more, 21%, of such gains. The tax treatment of dividend and interest income runs the gamut as well.

While it doesn’t hurt to research tax rates prior to making an investment - especially if you’re buying individual stocks and bonds - the IRS offers a way to avoid double taxation anyway. For any “qualified foreign taxes” that you’ve paid - and this includes taxes on income, dividends and interest - you can claim either a credit or a deduction (if you itemize) on your tax return.

So how do you even know if you’ve paid foreign tax? If you have any holdings abroad, you should receive either a 1099-DIV or 1099-INT payee statement at year’s end. Box 6 will show how much of your earnings were withheld by a foreign government. (The official IRS web site offers a basic description of the foreign tax credit here.)

In most cases, you’re better off opting for the credit, which reduces your actual tax due. A $200 credit, for examples, translates into a $200 tax savings. A deduction, while simpler to calculate, offers a reduced benefit. If you’re in the 25% tax bracket, a $200 deduction means you’re only shaving $50 off your tax bill ($200 x 0.25).

The amount of foreign tax you can claim as a credit is based on how much you’d be taxed on the same proceeds under U.S. tax law, multiplied by a percentage. To figure that out, you’ll have to complete Form 1116 from the Internal Revenue Service (download the form here).

If the tax you paid to the foreign government is higher than your U.S. tax liability, then the maximum foreign tax credit you can claim will be the U.S. tax due, which is the lesser amount. If the tax you paid to the foreign government is lower than your tax liability in the U.S., you can claim the entire amount as your Foreign Tax Credit. Say you had $200 withheld by an outside government, but are subject to $300 of tax at home. You can use that entire $200 as a credit to trim your U.S. tax bill.

Example 1

Now imagine just the opposite. You paid $300 in foreign taxes but would only owe $200 to the IRS for those same earnings. When your taxes abroad are higher, you can only claim the U.S. tax amount as your credit. Here, that means $200. But you can carry the remaining $100 over one year - if you completed Form 1116 and file an amended return - or forward up to 10 years.